Investment may be counted on the gross or the net basis. Net investment is gross investment minus depreciation. Investment may be ex-ante or planned or anticipated or intended investment; or it may be ex-post, i.e., actually realized investment, or when investment is not merely planned or intended, but which has actually been invested or implemented. This is so true when Buying Investment Properties.

Another classification of investment may be private investment or public investment. Private investment is on private account, i.e., by private individuals, and public investment is by the government. Private investment is influenced by marginal efficiency of capital i.e., profit expectations and the rate of interest. It is profit-elastic. Public investment is by the state or local authorities, such as building of roads, public parks etc. In public investment, profit motive does not enter into consideration. It is undertaken for social good and not for private gain.

Investment which is independent of the level of income, is called autonomous investment. Such investment does not vary with the level of income. In other words, it is income-inelastic. Autonomous investment depends more on population growth and technical progress than on anything else. The influence of change in income is not altogether ruled out, because higher income would probably result in more investment. But the influence of income is negligible as compared with the influence of population growth and progress of technical knowledge.

Examples of autonomous investment are long-range investments in houses, roads, public buildings and other forms of public investment. Most of the investment is undertaken to promote planned economic development. It also includes long-range investment to bring about technical progress or innovations. Public investment means investment which occurs in direct response to invention, and much of the long-range investment, which is only expected to pay for itself over a long period, can be regarded as autonomous investments.

Different sources define value investing differently. Some say value investing is the investment philosophy that favors the purchase of stocks that are currently selling at low price-to-book ratios and have high dividend yields. Others say value investing is all about buying stocks with low P/E ratios. You will even sometimes hear that value investing has more to do with the balance sheet than the income statement.

We think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).

Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.

Buffett’s definition of “investing” is the best definition of value investing there is. Value investing is purchasing a stock for less than its calculated value.

Tenets of Value Investing

1) Each share of stock is an ownership interest in the underlying business. A stock is not simply a piece of paper that can be sold at a higher price on some future date. Stocks represent more than just the right to receive future cash distributions from the business. Economically, each share is an undivided interest in all corporate assets (both tangible and intangible) – and ought to be valued as such.

2) A stock has an intrinsic value. A stock’s intrinsic value is derived from the economic value of the underlying business.

3) The stock market is inefficient. Value investors do not subscribe to the Efficient Market Hypothesis. They believe shares frequently trade hands at prices above or below their intrinsic values. Occasionally, the difference between the market price of a share and the intrinsic value of that share is wide enough to permit profitable investments. Benjamin Graham, the father of value investing, explained the stock market’s inefficiency by employing a metaphor. His Mr. Market metaphor is still referenced by value investors today:

Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

4) Investing is most intelligent when it is most businesslike. This is a quote from Benjamin Graham’s “The Intelligent Investor”. Warren Buffett believes it is the single most important investing lesson he was ever taught. Investors ought to treat investing with the seriousness and studiousness they treat their chosen profession. An investor should treat the shares he buys and sells as a shopkeeper would treat the merchandise he deals in. He must not make commitments where his knowledge of the “merchandise” is inadequate. Furthermore, he must not engage in any investment operation unless “a reliable calculation shows that it has a fair chance to yield a reasonable profit”.

5) A true investment requires a margin of safety. A margin of safety may be provided by a firm’s working capital position, past earnings performance, land assets, economic goodwill, or (most commonly) a combination of some or all of the above. The margin of safety is manifested in the difference between the quoted price and the intrinsic value of the business. It absorbs all the damage caused by the investor’s inevitable miscalculations. For this reason, the margin of safety must be as wide as we humans are stupid (which is to say it ought to be a veritable chasm). Buying dollar bills for ninety-five cents only works if you know what you’re doing; buying dollar bills for forty-five cents is likely to prove profitable even for mere mortals like us.

What Value Investing Is Not

Value investing is purchasing a stock for less than its calculated value. Surprisingly, this fact alone separates value investing from most other investment philosophies.

True (long-term) growth investors such as Phil Fisher focus solely on the value of the business. They do not concern themselves with the price paid, because they only wish to buy shares in businesses that are truly extraordinary. They believe that the phenomenal growth such businesses will experience over a great many years will allow them to benefit from the wonders of compounding. If the business’ value compounds fast enough, and the stock is held long enough, even a seemingly lofty price will eventually be justified.

Some so-called value investors do consider relative prices. They make decisions based on how the market is valuing other public companies in the same industry and how the market is valuing each dollar of earnings present in all businesses. In other words, they may choose to purchase a stock simply because it appears cheap relative to its peers, or because it is trading at a lower P/E ratio than the general market, even though the P/E ratio may not appear particularly low in absolute or historical terms.

Should such an approach be called value investing? I don’t think so. It may be a perfectly valid investment philosophy, but it is a different investment philosophy.

Value investing requires the calculation of an intrinsic value that is independent of the market price. Techniques that are supported solely (or primarily) on an empirical basis are not part of value investing. The tenets set out by Graham and expanded by others (such as Warren Buffett) form the foundation of a logical edifice.

Although there may be empirical support for techniques within value investing, Graham founded a school of thought that is highly logical. Correct reasoning is stressed over verifiable hypotheses; and causal relationships are stressed over correlative relationships. Value investing may be quantitative; but, it is arithmetically quantitative.

There is a clear (and pervasive) distinction between quantitative fields of study that employ calculus and quantitative fields of study that remain purely arithmetical. Value investing treats security analysis as a purely arithmetical field of study. Graham and Buffett were both known for having stronger natural mathematical abilities than most security analysts, and yet both men stated that the use of higher math in security analysis was a mistake. True value investing requires no more than basic math skills.

Contrarian investing is sometimes thought of as a value investing sect. In practice, those who call themselves value investors and those who call themselves contrarian investors tend to buy very similar stocks.

Let’s consider the case of David Dreman, author of “The Contrarian Investor”. David Dreman is known as a contrarian investor. In his case, it is an appropriate label, because of his keen interest in behavioral finance. However, in most cases, the line separating the value investor from the contrarian investor is fuzzy at best. Dreman’s contrarian investing strategies are derived from three measures: price to earnings, price to cash flow, and price to book value. These same measures are closely associated with value investing and especially so-called Graham and Dodd investing (a form of value investing named for Benjamin Graham and David Dodd, the co-authors of “Security Analysis”).

Conclusions

Ultimately, value investing can only be defined as paying less for a stock than its calculated value, where the method used to calculate the value of the stock is truly independent of the stock market. Where the intrinsic value is calculated using an analysis of discounted future cash flows or of asset values, the resulting intrinsic value estimate is independent of the stock market. But, a strategy that is based on simply buying stocks that trade at low price-to-earnings, price-to-book, and price-to-cash flow multiples relative to other stocks is not value investing. Of course, these very strategies have proven quite effective in the past, and will likely continue to work well in the future.

The magic formula devised by Joel Greenblatt is an example of one such effective technique that will often result in portfolios that resemble those constructed by true value investors. However, Joel Greenblatt’s magic formula does not attempt to calculate the value of the stocks purchased. So, while the magic formula may be effective, it isn’t true value investing. Joel Greenblatt is himself a value investor, because he does calculate the intrinsic value of the stocks he buys. Greenblatt wrote The Little Book That Beats The Market for an audience of investors that lacked either the ability or the inclination to value businesses.

You can not be a value investor unless you are willing to calculate business values. To be a value investor, you don’t have to value the business precisely – but, you do have to value the business.

No matter what kind of investing you do – bonds, stock options, mutual funds, gold, commodities, real estate – in order to be successful you need to have a thorough understanding of your personal investment style. Some investors are risk takers, some investors are conservative, some investors are a combination of the two, depending on their cash position and the form of the investment. Understanding your personal risk tolerance and investment style will aid you in making smart investment choices.

While there are many different types of investments, there are only three specific investment styles – and those three styles directly relate to your risk tolerance. The three investment styles are: conservative, moderate, and aggressive. These styles are dependent upon your tolerance of risk and how much time you’re willing to invest in … your investing.

For example, some investment strategies may have you watching prices go up and down continually throughout the day. Are you equipped to handle these changes, especially if they don’t go your way? Other ventures may place your entire investment at risk. You could lose all your money. Is that something that would weigh heavily on your mind, possibly affecting the way you handle the investment? Do you panic easily? Are you able to stick to the numbers and the plan they represent, with clear cut entry and exit points? Or are you the type to watch an investment dive and toss out the original plan in the hope that the investment will eventually come back?

Also important to consider: how involved do you want to be in your investments? Do you want to trade daily and make a career out of it? Do you want to overlook and control every aspect of your investments? Or would you prefer a more passive role, spending only an hour a week or a month in making sure everything appears on track? Do you prefer to do your own research or rely on the research of others?

The next consideration is your life situation. For instance, if you’re investing for your retirement and you’re in your early twenties, a conservative or moderate approach to your investments is often the best road to take. However, if you’re investing for your retirement and you’re in your mid-fifties, you may have to be more aggressive, and therefore a little riskier in your investments. In the same vein, if you’re trying fund your first house, your approach will generally be more aggressive because your time-line for generating profits will be dramatically shorter than if you were simply working toward a goal such as retirement.

Conservative investors want to preserve their initial investment. If they invest $5000, they want to be sure that they’ll get their initial $5000 back. Common stocks and bonds, short term money market accounts, Treasury notes, high-rated municipal bonds, CDs, even interest earning savings accounts are generally preferred investments for this type of investor. They tend to steer clear of stocks, since stocks can loose their value.

A moderate investor invests similarly to a conservative investor, with the goal of increasing the value of their investments without risking any major losses. They’ll generally use a portion of their investment funds for higher risk investments. Many moderate investors invest 50% of their funds in safe or conservative investments, with the remainder in something slightly riskier (blue chip stocks, for example).

An aggressive investor is looking for significant gains, and he’s willing to go out on a limb with his initial investment to achieve these gains. Individual stocks, stock mutual funds, stock options, and some of the speculative markets are all potential investments for the aggressive investor. Larger returns, generally in the short run, are the goal here.

Determining the style of investing that best fits your personality, life situation, and financial goals is the most important step toward making successful investments. However, no matter which approach to investing you take, always do your due diligence. Never invest without having all of the facts.